The average monthly payment for new mortgage borrowers increased at a higher rate than the increase in average household income says a Bank of Israel study by Dr. Golan Benita and Dr. Ziv Naor. They state that, in 2008-2012, the average price of a home rose 54%, while average household income rose by 20%, raising the question how new homebuyers financed the sharp increase in home prices, and has it affected their ability to repay their mortgages.
The study found that while Israelis' average mortgage payment to income ratio was higher than in the US and EU, its household debt to GDP ratio was lower: Israelis' average mortgage payment to income ratio is over 30%, compared with an average of 17% in the US and 22% in the EU; but Israel's household debt to GDP ratio is 45%, compared with 49% in the EU and 85% in the US.
One of the main indicators of borrowers’ repayment ability is the payment to household income ratio. This indicator is affected by the development of borrowers’ income and the size of the monthly payment, which depends on the size of the mortgage, the duration of the mortgage, and the development of interest and inflation rates. Empirical studies from around the world indicate that when a borrower’s payment to income ratio is greater than a specific level, the probability of default increases markedly. Furthermore, research that has studied the link between financial crises and the payment to income ratio have found that a sharp increase in the payment to income ratio serves as a signal of a systemic banking crisis, and the sharper the increase in the payment to income ratio, the deeper the ensuing crisis. Therefore, from macroprudential perspectives, there is considerable importance to monitoring the development of the distribution of borrowers’ payment to income ratios in banks’ housing credit portfolios, and particularly in light of the sharp increase in that balance over the previous five years.
Results of the research indicate that due to the sharp increase in mortgage sizes in recent years, despite the sharp decline in interest rates on mortgages over this period, and new mortgage borrowers taking out loans with longer repayment terms than in the past. This development led to a marked increase in borrowers’ risk levels in banks’ housing credit portfolios, which was reflected by a sharp increase in both mortgage borrowers’ payment to income ratio, which is currently high compared with other countries, and the share of high risk mortgages (with payment to income ratios above 40%). It should be noted that before the increase in home prices, borrower risk in Israel was similar to levels worldwide.
In addition to the historical development of the distribution of the payment to income ratio, the researchers estimate expected developments under several scenarios. Under the first scenario, the researchers assume that home prices will continue to increase in the first year by a similar rate to that of the past two years and afterward will develop in line with the expected inflation rate; average household income will increase in line with its average growth rate in recent years; and inflation and interest rates will develop in line with expectations derived from the capital markets.
The study finds that under this scenario, borrowers’ risk in the mortgage market is will grow in the coming years because of the continued rise in home prices, which will affect the payment to income ratio of new buyers, and the expected increase in the interest rate, boosting the monthly payments on floating rate mortgages. The share of these mortgages in total mortgage volume increased sharply from 2009-11, reaching a record high rate of about 80% right before Supervisor of Banks David Zaken capped the share of the floating rate component of a mortgage. As a result, the share of mortgage borrowers’ average monthly repayment in banks’ housing credit balances is very sensitive to changes in the interest rate.
In addition to the scenario of continued rise in home prices, the researchers assessed the development of the payment to income ratio distribution under two stress scenarios, which are based on the 2002-03 economic crisis: a sharp increase in the interest rate and a recession, which will include a fall in wages and higher unemployment. The researchers assume that home prices will react to changes in the interest and unemployment rates with the same elasticity found in previous research. They found that under both scenarios, borrower risk in the mortgage market will increase sharply and is liable to result in an increase in default rates. The findings indicate that the effect on borrower risk of a recession in real economic activity is more significant. Furthermore, this scenario potentially contains an even greater risk since,- as found in numerous studies worldwide: increased unemployment is one of the main risk factors for defaults, especially for borrowers with a high payment to income ratio.
Dr. Benita and Dr. Naor say that, as a result of the sharp increase in home prices in recent years, banks’ potential credit loss in the scenario involving defaults declined markedly for mortgages taken out before home prices increased, or in the early stages of the price appreciation. However, it is likely that in a scenario of a sharp increase in defaults with declines in home prices (as expected under the stress scenarios), banks will find it difficult to sell a large number of properties, which is liable to send home prices down further and worsen the banks’ credit losses, as occurred in financial crises in other countries.
Zaken's directive, published in August, limiting the payment to income ratio, the term to the repayment, and the share of the floating rate component in mortgages, work to reduce those risks.
Published by Globes [online], Israel business news - www.globes-online.com - on September 15, 2013
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